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Bad Stocks Are All Around Us: Finding the Next Enron

Does your portfolio contain the next Enron or Worldcom? Use these lessons to help unlock financial shenanigans.

"The most important thing we do is meet our numbers. It's more important than any individual product; it's more important than any individual philosophy; it's more important than any individual cultural change we're making. We stop everything else when we don't make the numbers."

Those words were spoken by former Qwest CEO Joe Nacchio in January 2001, months before Qwest began a precipitous decline from the mid-$30s to a low of nearly $1 by August 2002. Qwest was ultimately accused by the SEC of perpetuating a $3 billion financial fraud. Nacchio resigned in June 2002 and was later convicted of insider trading and carted off to jail.

The Qwest case was just one of many thought-provoking examples of financial chicanery shared by Dr. Howard Schilit during a presentation of his I attended last month. Whether talking about Computer Associates, Enron, Symbol Technologies, or WorldCom, stories from the great business frauds of the past decade never seem to lose their luster. Yet it was the Qwest example and Nacchio's quote in particular that inspired Schilit to write the third edition of Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports -- a must-read for investors, particularly those who are aiming to short stocks for profit.

Though a great deal of Schilit's presentation was devoted to talking up the book, here are the most memorable takeaways:

Revenue recognition is key: This is a critical red flag -- and Schilit agrees that most major accounting fraud is started by manipulating revenue. Look at Enron. Everyone talks about how it hid massive amounts of debt by using exotic off-balance-sheet arrangements, but to Schilit, that was a mere sideshow compared with what was going on in its revenue. Enron went from $10 billion to $100 billion in revenue in four years. The average company that's breached the $100 billion threshold (and there have only been a handful) took 25 years to hit that mark. When trying to spot revenue recognition problems, keep an eye on receivables growth versus sales growth and companies that use percentage-of-completion accounting.

Get to know management's incentives: Schilit believes a company's proxy statement is a must-read. Compare the management team's incentives with what they were a year ago. If there are any major changes, it's a red flag. And look for a revolving door at the chief financial officer's suite.

Be fearful when others are greedy: Financial fraud gets particularly ripe during boom periods. Everyone, says Schilit, including those on Wall Street, will do everything they can to keep the party going.

Don't trust accounting firms: Schilit says the quality of public auditors is "shockingly bad." It's crazy to see the kind of shenanigans they're willing to sign off on. Despite all the frauds, SEC suits, and Sarbanes-Oxley regulations, the accounting firms still don't get it.

A simple indicator of fraud: The stock market loves smooth and predictable, and that's what many managers strive for. Schilit says to look at companies that consistently meet or exceed Wall Street's consensus earnings estimates -- and to be especially wary of managers that publicly tout their earnings-guidance track record.

That last point reminded me of a quote I recently came across: "Hopefully, it speaks a bit for itself. During the last 10 quarters, we have met at the high-end or exceeded our guidance ranges for both revenue and EPS." That quote is from Chief Financial Officer Bob Hult in a recent presentation to investors discussing Mercury Computer Systems earnings track record. Mercury, by the way, happens to be a favorite short idea of John Del Vecchio's, our resident Motley Fool bear.

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Matthew Argersinger doesn't own any of the stocks mentioned in this article. Mercury Computer Systems is aMotley Fool Big Shortshort-sale recommendation. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.